Varied policy action


At the onset of the pandemic, policymakers around the world were synchronized in dramatically easing monetary policy and expanding fiscal policy. These actions helped prevent a global financial crisis, despite lockdowns and health shocks causing a historic recession. The confluence of very low inflation and weak demand provided a strong rationale for easy monetary policies.


Earlier this year, when inflation picked up sharply, it was driven by exceptionally high inflation in a few sectors such as energy and autos, much of which was expected to reverse by the end of the year as pandemic related disruptions declined. Central banks, with a long track record of keeping inflation low and stable could appropriately “look through” the runup in inflation and keep interest rates low to support the economic recovery.


However, risks of a further acceleration of inflation previously flagged in our global publications and country-specific reports are materializing, with supply disruptions and elevated demand lasting longer than expected. Inflation is likely to be higher for longer than previously thought, which means that real rates are even lower than before, implying an increasingly expansionary stance of monetary policy.


While we still anticipate that supply-demand imbalances will wane next year, a singular focus of monetary policy on supporting recovery may well fuel substantial and persistent inflationary pressures, with some risk of de-anchoring inflation expectations. Accordingly, in countries where economic recoveries are further along and inflationary pressures more acute it would be appropriate to accelerate the normalization of monetary policy.


Potentially challenging spillovers


The challenge of addressing large and persistent supply shocks is even greater for emerging market central banks. Given the greater risk to de-anchoring of inflation expectations relative to advanced economies, they see the need to get ahead of inflationary pressures and some—such as Brazil and Russia—have raised policy rates sharply. Such tightening comes amid large COVID-related output shortfalls and could further depress output and employment. Emerging markets face potentially challenging spillovers if tightening by advanced economies causes capital outflows and exchange rate pressures that could require them to tighten even more.


Lastly, there remains tremendous uncertainty around the evolution of the pandemic and on its economic consequences. A variant that significantly reduces vaccine efficacy could lead to further supply chain disruptions and contractions in labor supply pushing up inflationary pressures, while lower demand could have opposing effects. The sharp fall in oil prices following the discovery of Omicron and the rapid imposition of travel restrictions by countries is a sign of the volatility ahead.


In sum, policymakers must carefully calibrate their response to incoming data. Varying inflation conditions and strength of recoveries across countries show why the policy response needs to be tailored to country specific circumstances, given sharply higher uncertainty associated with Omicron. Clear central bank communication, too, is key to fostering a durable global recovery.


As we warned in recent reports such as the World Economic Outlook, a more frontloaded Fed response to dampen inflation risks could result in market volatility and create difficulties elsewhere—especially in emerging and developing economies. To avoid that, policy shifts need to be telegraphed well, as has so far been the case. Emerging market and developing economies should also prepare for increases in advanced economy interest rates through debt maturity extensions where feasible, thereby reducing their rollover needs, and regulators should also focus on limiting the buildup of currency mismatches on balance sheets.


This article was originally published by World Economic Forum, on December 10, 2021, and has been republished in accordance with the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Public License. You can read the original article here. The views expressed in this article are those of the author alone and not of the WorldRef.


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